Cap and trade lessons from the Northeast.

With all the hand-wringing over the alleged risk of market manipulation in cap and trade, you’d almost forget that the United States already has a carbon cap and trade program up and running. But it does.

RGGI, a regional program among 10 Northeast states, has been auctioning permits, allowing trading on a secondary market, and even, in a way, encouraging trading in derivatives. And guess what’s happened so far?

…we find no evidence of anticompetitive conduct. Participation by a large number of firms is an encouraging sign of competitiveness and efficiency in the secondary market.

That’s according to a May 2009 report (pdf) by Potomac Economics, the designated market monitor tasked with keeping a close eye on RGGI’s market function. It’s the most recent analysis available and it’s an encouraging sign. But really, it’s no accident that RGGI has been successful so far. Administrators have prized transparency, regulation, and oversight in ways that can usefully inform federal cap-and-trade legislation.

1. Keep trading transparent. Ownership of RGGI permits are are registered in a public tracking system. Futures and options are exchange-traded on the Chicago Climate Futures Exchange and the Green Exchange. Smart, because:

Public exchanges are attractive to firms that need a simple way to trade standard products. Moreover, public exchanges effectively eliminate the risk of default by counter-parties, since the exchange constantly monitors the account holdings of each participant to ensure that they have posted sufficient financial security to meet their obligations.

RGGI does allow over-the-counter (OTC) trades (trades between two private parties) for futures, options, and other derivative products. While OTC markets do provide some benefits for certain firms, they are murkier than public exchanges. And even the public exchanges may not require all the details that are important to understanding a transaction. (Potomac identified one instance in which a small quantity of allowances was traded at a price that seems too high—and though there are a number of perfectly reasonable explanations for the trade, the exchanges did not require sufficient information from the trading parties to allow the market monitor to draw conclusions.)

2. Keep a level playing field. RGGI publicly announces the “clearing price” of its auction a pre-specified time so that all participants have access to the same information and the same time. Similarly, the US Commodity Futures Trading Commission publishes a weekly report documenting the positions, both long and short, of firms trading futures and options on the commodity exchanges. Once again, market participants operate with shared information, which curbs manipulation.

3. Keep an eye on the ball. Frequent analytical reports, like this one from Potomac, are key to ensuring that the carbon markets are well-functioning and fair. Good market monitoring can enable government regulators and administrators to act in a timely fashion if something goes awry. And they can fine-tune their policies and procedures based on good information.

They also allow the public to breath easier given all the recent nervousness about derivatives. And derivatives and secondary markets are important, as the report notes, for at least three reasons:

First, it gives firms an ability to obtain allowances at any time during the three months between the RGGI auctions. Second, it provides firms a way to protect themselves against the potential volatility of future auction clearing prices. Third, it provides price signals that assist firms in making investment decisions in markets affected by the cost of RGGI compliance.

This may all sound dull, but it’s serious stuff. Well-functioning secondary markets keep costs low they help firms to take a carefully planned, financially prudent path to reducing their emissions. All of which is excellent for the public— and excellent for the planet.

You know what they say in the financial world: “past performance is no guarantee of future results.” But that doesn’t mean we can’t learn lessons from past performance. One lesson RGGI teaches, I think, is that it’s perfectly possible to run a well-functioning carbon cap and trade market. The challenge now is doing it on a bigger canvas.

Comments

Oregon Michelle

November 12, 2009 at 7:13 pm

Sightline, thanks for this great “front-row seat view” of U.S. cap and trade—but you gotta get your geography right! The RGGI lists 10 Northeastern and MID-ATLANTIC states in its report. This is very important for visualizing clearly which U.S. states are currently participating. (And just to be SUPER-CLEAR, Pennsylvania ain’t one of them, either—yet.)

With all the hand-wringing about people expressing their concerns about the efficacy of cap and trade which—to the extent it succeeds without an ENRON or a Government-Sachs takeover—can only approach the efficiency and resiliency of carbon tax, it’s dispiriting to see every article on the subject written in such a slanted fashion, positing that people skeptical about cap and trade are “hand wringing.”I trust Potomac Enterprises reports about as much as I trust any of the reports by consulting firms who are working to get a city to give a big subsidy to a sports team—it is clear who hires the consultant and where the future money for the consultant comes from.

Ok, the report is saying a secondary carbon market is important because of problems with the auction market for carbon allowances. So, why did we need the auction market again? Oh, that’s right, so cheap carbon allowances can be negotiated by special interests and later be sold for a large profit. And with a carbon trading market, momentum and arbitrage trades can be made against volatility. And management fees can be extracted from offset pools, with offsets specifically picked for maximum profit, regardless of how effective it actually is. But, why do we need any of this? Why not just have industry pay a carbon tax on the actual emissions? There wouldn’t be any volatility and there would be solid price signals. Well, it is just too simple to easily get a hook into the money flow.Whatever your opinion about carbon taxes and cap-and-trade, why isn’t congress honestly debating the pros and cons of each? Why does the senate finance committee hold a hearing – not on climate finance – but on jobs for special interests? Is opposition to carbon taxes really just about the word tax? This report claims there hasn’t been any market manipulation in the RGGI – yet. Have you wondered why the financial industry has been so quiet about the carbon market debate, after successfully slipping carbon trading into both the house and senate climate bills with no restrictions? Well, if you were sitting on a gold mine, what would you do? The last thing you would do, is potentially disrupt a small cap-and-trade market before carbon trading becomes law. And if a carbon trading market is worth trillions, why not throw a couple of billion at congress with cheap money available after the bailout? That is a real risk, because money is key for congressmen to get re-elected.

It might be worth noting that clearing prices in all the RGGI auctions have been consistent with allowance prices in the secondary market. There is no evidence of auction malfunction or windfall profiteering, as described in the post above. In addtion, it might be worth noting that the RGGI states only accept offsets in five, quite prescriptive categories (http://www.rggi.org/offsets/offset_requirements)—and they only allow emitters to use those offsets to cover a very small fraction (3.3%) of their emissions.

Good discussion.It might also be worth noting on this page that the 3.3% “may be expanded to 5 percent and 10 percent if certain CO2 allowance price thresholds are reached.”If we’re going to start as small as 3.3%, then let’s start with something more efficient, like a carbon tax. Then, let’s expand that to 5% and 10%. PS: Wikipedia defines the Northeastern United States as including the Mid-Atlantic states, so, Sightline, y’all are correct. But Pennsylvania is still holding out on any trading schemes, as yet. 🙂

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